The New Endowment Portfolio

Submitted by Jim Wolfston on April 9, 2009 - 3:00am

Cornell University and Citigroup would seem to have very little in common aside from the fact that Citi’s former chairman, financial deal-maker Sandy Weill, is a noted Cornell graduate who has given generously[1] to his alma mater.

But there’s another, more significant commonality. Both institutions are suffering immense pain and dislocation because their balance sheets are tarnished with illiquid assets. As with Citi’s balance sheet, the plummeting financial markets have ripped a hole in Cornell’s endowment, which was heavily invested in private equity, real estate and hedged equity instruments. It’s unclear exactly how big a loss Cornell’s endowment has thus far suffered, since a large chunk of the university’s portfolio consists of illiquid, complex and hard-to-value assets. But for now, the decline is officially put at 27 percent for the last six months of 2008.

Cornell is far from alone in grappling with the fallout from endowment losses. The overall value of university endowments in the United States fell about 23 percent on average for the five months ending November 30, 2008.

The steep declines are forcing many colleges and universities to adopt wage freezes, layoffs and a halt to on-campus construction projects. The hope, of course, is that endowment losses don’t ultimately cut into or curtail financial aid for students. But, given the markets’ continued turmoil as we head toward the end of the first quarter of 2009, students will be inevitably impacted.

The Clubby Origins of Decline

How did we get to this painful point?

During the past decade, universities stood by as competing investment managers pushed more and more of their endowment money toward increasingly risky bets. So long as the game was rolling, endowment managers could report outsize returns while drawing hefty compensation. During the halcyon days, Harvard investment manager Jack Meyer hinted at the clubby competition in a jacket blurb for his Yale counterpart’s new book, Pioneering Portfolio Management: “A masterful work by the master himself. We at Harvard wish that David Swensen would find a new job.”

Indeed, playing high-stakes poker with other people's money is a great game, particularly when you can claim a cut of the winnings. It gets even better when you can take full credit as the stacks of chips get taller and taller, even though donors keep shoving high denomination chips your way. But now that we’ve reached the financial reckoning, the poker games should finally be seen for what they were.

The New York Times hints that Harvard’s illiquidity problems trace to endowment decisions under the recent guidance of Mohamed El-Erian. Harvard’s Meyer draws a pass as the Times lumps him into a group of "legendary predecessors." But this analysis fails to admit that Meyer and Yale’s Swensen were part of a vanguard who pushed portfolio management increasingly towards alternative asset classes.

The legend spinning should better reflect the fact that the clubby competition between managers for juicing returns led to widespread pouring of endowment money into opaque investments. The simple truth is that opacity equals infinite risk, and infinite risk doesn’t compute and will never balance.

Endorsing the Casino Society

Perhaps most troubling is the fact that the puerile competition among investment managers chasing higher and higher returns led colleges and universities to effectively endorse the conduct and structure of the shadow banking system. It is the lack of transparency and lack of regulation in this shadow banking system that encouraged overleveraged bets on exotic, and now illiquid, CDOs and CMOs – bad assets now smoldering at the center of our current economic meltdown. How can aligning institutional prestige with the shadow banking system – an alignment that flowed from avarice for higher and higher returns – square with university mission statements that aver commitment to the common good?

The fact is that allocating even a single dollar of endowment money to the hedge fund kin of the Greenwoods, Madoffs and Stanfords – all of whom insisted on opacity – had nothing to do with balancing risk or upholding fiduciary responsibility. It’s the first job of any endowment manager to understand what the hell is going on.

Accountability

After so many years of strong returns, should one very bad year be allowed to tarnish the reputations of so many college and university endowment managers? The answer is clearly “yes” – if accountability and transparency are indeed going to play a larger role in the management of money in our post-Madoff culture.

Another step towards more accountability would be to dispense with what economists term the “money illusion” when reporting endowment performance. The money illusion assesses risk and reports economic performance in nominal versus real purchasing terms. For example, on December 16, 2008 president Richard Levin explained to Yale faculty and staff that: “Our best estimate of the Endowment’s value today is $17 billion, a decline of 25 percent since June 30, 2008.” But what this “best estimate” failed to point out is that in real dollar terms, Yale’s sudden six-month loss wiped out the reported endowment return of 22.9% for fiscal 2006, the reported 28.0% return for fiscal 2007, and the reported return of 4.5% for fiscal 2008! By the Higher Education Price Index, the six month loss had set the Yale endowment back nearly four years to the same purchasing power it held as of June 30, 2005.

Giving Back

The Commonfund reports that by December 2008, college endowments had suffered estimated average six-month losses of 24.1 percent.[2] It is now expected that by the end of the fiscal year (June ’09), full-year losses will be even greater. Already the widespread carnage is being rationalized by comparing results to similar or greater losses in the broader equity markets. But the fact remains that epic losses have no precedent in endowment management. For example, Harvard’s endowment actually grew during ’29-’32--the most devastating years of the Great Depression.

Will endowment managers, who in recent years sought to juice returns by leveraging endowment monies into hedge funds and other corners of the shadow banking system now be held accountable? And can we expect them to give back any of the lavish investment-banker level bonuses they were paid during the go-go years?

We’ll surely be waiting a long time for this kind of accountability. But perhaps we can hope that in the face of huge losses, universities will begin reappraising the ego-driven competition around celebrity investment managers while re-acknowledging the central importance of contributions to the long term health of the endowment. Then, perhaps, we might realistically hope that rather than placing monies into exotic investments, they will think about putting money to work in ways that stimulate and inspire donors over the long haul.

Endowments Are Not Mutual Funds

Because of the essential nature of contributions, the management of endowment monies can and should be approached differently from the management of mutual funds, retirement funds or pension monies. In these latter realms, maximizing short-term measurable investment returns plays a key role. Since donations are absent, there can be no strategic initiative to increase them. By contrast, the power and importance of contributions in university endowments opens novel strategic opportunities around which endowment managers must learn to creatively think and act.

Swensen noted in his book that since 1950, approximately two-thirds of Yale’s endowment corpus was ultimately attributable to gifts. “Note the importance of new gifts to the endowment, with roughly two-thirds of 1998’s targeted value stemming from gifts made since 1950. In other words, in the absence of new gifts over the past forty-eight years, Yale’s endowment would likely total only about one-third of today’s value.” Given the importance of gifts, and in view of the financial meltdown, college and universities might now consider new ways of investing such as placing money alongside constituents who are likely to contribute.

Why not, for example, allocate part of the endowment to first-time mortgages for graduates, faculty and administrators? If a university advanced the 20 percent cash down payment for a young graduate’s first home while bargaining for, say, 30 percent of the capital gain at the time the house sold, the university would, over time, enjoy a solid return. But more importantly, each such investment would powerfully reinforce allegiance from a potential contributor or donor.

Similarly, if the college on its own, or in concert with other institutions, pooled venture funds to invest in the new and creative businesses of its own graduates, the endowment fund manager might negotiate for the college a small percentage royalty as a return on invested capital until a transaction event for the business took place. Again, returns would come not only in measurable cash, but also in immeasurable allegiance and appreciation.

Or how about applying endowment monies toward microloans for third-world nations, or as debt financing for worthy initiatives on the energy or microbiology fronts here at home? While the short-term cash returns might not be as sexy as those earned during the endowment bubble, the long-term returns in goodwill from future contributors would be significant.

Of course, even if the relative power of contributions in endowment growth gets the reconsideration it deserves, most colleges won’t adopt anything like what I am proposing here because they will worry that the returns would be too low. But whether returns would or would not be too low following such basic strategy changes is fundamentally an empirical question. In the face of crashing returns, now is the time to rethink.

Looking at the Obama campaign as an example, it is obvious that millions of people contributing small amounts can overwhelm the traditional large donor focus for campaign funding and finance. (To be sure, plenty of large donors were also making contributions to the Obama campaign as wealthy people were also inspired.) What might happen for universities if more ordinary people also became genuinely inspired to give to higher education? That inspiration hasn’t happened (note the very low alumni participation rates in giving) and won’t happen as long as the basic message from higher education remains how “prestigious” colleges are, and how “legendary” their endowment managers happen to be.

Colleges and universities need to comprehend and act on the fact that endowments are different from pension or retirement funds owing to the critical importance of protecting and enhancing contributions. If deployed creatively, today’s $400 billion in higher education endowments could become a great power for good that would inspire students, graduates and constituents – the people who hold the real potential for growing endowments over the long term.

Note: An earlier version of this essay applied an incorrect formula to Yale's investment return that was derived from a table published in the 2008 Yale Endowment report. Yale has since provided to the editor supplementary data and a formula contesting the earlier calculation. The author agreed to remove his earlier calculation based on the information provided by Yale.